1. CHAPTER 10 Financial Preparation for Entrepreneurial Ventures
© 2007 Thomson/South-Western. All rights reserved.

2. Chapter Objectives
Studying this chapter should provide you with the entrepreneurial knowledge needed:
To explain the principal financial statements needed for any entrepreneurial venture: the balance sheet, income statement, and cash-flow statement
To outline the process of preparing an operating budget
To discuss the nature of cash flow and to explain how to draw up such a document
To describe how pro forma statements are prepared
To explain how capital budgeting can be used in the decision-making process
© 2007 Thomson/South-Western. All rights reserved.
10–2

3. Chapter Objectives (cont’d)
Studying this chapter should provide you with the entrepreneurial knowledge needed:
To illustrate how to use break-even analysis
To describe ratio analysis and illustrate the use of some of the important measures and their meanings
To describe the value of decision support systems in the management of financial resources
© 2007 Thomson/South-Western. All rights reserved.
10–3

4. The Importance of Financial Information for Entrepreneurs
Significant Information for Financial Management
The importance of ratio analysis in planning
Techniques and uses of projected financial statements
Techniques and approaches for designing a cash-flow schedule
Techniques and approaches for evaluating the capital budget
© 2007 Thomson/South-Western. All rights reserved.

5. Table 10.1 A Financial Glossary for the Entrepreneur
© 2007 Thomson/South-Western. All rights reserved.

6. Table 10.1 A Financial Glossary for the Entrepreneur (cont’d)
© 2007 Thomson/South-Western. All rights reserved.

7. Table 10.1 A Financial Glossary for the Entrepreneur (cont’d)
© 2007 Thomson/South-Western. All rights reserved.

8. Understanding the Key Financial Statements
Balance Sheet
Represents the financial condition of a company at a certain date.
It details the items the company owns (assets) and the amount the company owes (liabilities).
It also shows the net worth of the company and its liquidity.
Assets = Liabilities + Owners’ Equity
An asset is something of value the business owns.
Current and fixed assets
Liabilities are the claims creditors have against the company.
Short- and long-term debt
Owners’ equity is the residual interest of the firm’s owners in the company.
© 2007 Thomson/South-Western. All rights reserved.

9. Table 10.2 Kendon Corporation Balance Sheet for the Year Ended December 31, 2006
© 2007 Thomson/South-Western. All rights reserved.

10. Understanding the Key Financial Statements (cont’d)
Income Statement
Commonly referred to as the P&L (profit and loss) statement from activities of the firm.
Provides the results of the firm’s operations.
Income Statement Categories
Revenues: gross sales that the business made for the period
Expenses: Costs associated with producing goods or services
Net Income: The excess (deficit) of revenues over expenses (profit or loss)
© 2007 Thomson/South-Western. All rights reserved.

11. Table 10.3 Kendon Corporation Income Statement for the Year Ended December 31, 2006
© 2007 Thomson/South-Western. All rights reserved.

12. Understanding the Key Financial Statements (cont’d)
Statement of Cash Flow
An analysis of the cash availability and cash needs of the business that shows the effects of a company’s operating, investing, and financing activities on its cash balance.
How much cash did the firm generate from operations?
How did the firm finance fixed capital expenditures?
How much new debt did the firm add?
Was cash from operations sufficient to finance fixed asset purchases?
The use of a cash budget may be the best approach for an entrepreneur starting up a venture.
© 2007 Thomson/South-Western. All rights reserved.

13. Table 10.4 Format of Statement of Cash Flows
© 2007 Thomson/South-Western. All rights reserved.

14. Preparing Financial Statements
Budget
One of the most powerful tools the entrepreneur can use in planning financial operations.
Operating Budget
A statement of estimated income and expenses over a specified period of time.
Cash Budget
A statement of estimated cash receipts and expenditures over a specified period of time.
Capital Budget
The plan for expenditures on assets with returns expected to last beyond one year.
© 2007 Thomson/South-Western. All rights reserved.

15. The Operating Budget Forecasting
Creating an operating budget through preparation of the sales forecast.
Linear regression: a statistical forecasting technique.
Y = a + bx
Y is a dependent variable—its value is dependent on the values of a, b, and x.
x is an independent variable that is not dependent on any of the other variables
a is a constant.
b is the slope of the line of correlation (the change in Y divided by the change in x).
© 2007 Thomson/South-Western. All rights reserved.

16. Figure 10.1 Regression Analysis
© 2007 Thomson/South-Western. All rights reserved.

17. Table 10.5 Wheatman’s Market: Sales Forecast for 20XX ($000)
© 2007 Thomson/South-Western. All rights reserved.

18. Table 10.6 Wheatman’s Market: Purchase Requirements Budget for 20XX ($000)
© 2007 Thomson/South-Western. All rights reserved.

19. Table 10.7 General Widgets: Production Budget Worksheet for 20XX ($000)
© 2007 Thomson/South-Western. All rights reserved.

20. The Cash-Flow Budget Cash-Flow Budget
Provides an overview of the cash inflows and outflows during the period. By pinpointing cash problems in advance, management can make the necessary financing arrangements.
Preparation of the cash-flow budget
Identification and timing of three cash inflows:
Cash sales
Cash payments received on account
Loan proceeds
Minimum cash balance
© 2007 Thomson/South-Western. All rights reserved.

21. Table 10.8 Wheatman’s Market: Expense and Operating Budgets
© 2007 Thomson/South-Western. All rights reserved.

22. Table 10.9 Wheatman’s Market: Cash-Flow Budget
© 2007 Thomson/South-Western. All rights reserved.

23. Pro Forma Statements Pro Forma Statements
Projections of a firm’s financial position over a future period (pro forma income statement) or on a future date (pro forma balance sheet).
Using beginning balance sheet balances, the projected changes depicted on the operating and cash-flow budgets are added to create the projected balance sheet totals.
© 2007 Thomson/South-Western. All rights reserved.

24. Table 10.10 Wheatman’s Market: Pro Forma Statements
© 2007 Thomson/South-Western. All rights reserved.

25. Table 10.10 Wheatman’s Market: Pro Forma Statements (cont’d)
© 2007 Thomson/South-Western. All rights reserved.

26. Capital Budgeting The Capital Budgeting Process
Identification of cash inflows or returns and their timing
The inflows are equal to net operating income before deduction of payments to financing sources but after deduction of applicable taxes and with depreciation added back, as represented by the following formula: Expected Returns = X(1 – T) + Depreciation
X is equal to the net operating income
T is defined as the appropriate tax rate
Capital Budgeting Objectives
Which of several mutually exclusive projects should be selected?
How many projects, in total, should be selected?
© 2007 Thomson/South-Western. All rights reserved.

27. Table 10.11 North Central Scientific: Expected Return Worksheet
© 2007 Thomson/South-Western. All rights reserved.

28. Capital Budgeting (cont’d)
Payback Method
Considers the length of time required to “pay back” (recapture) the original investment.
Any project that requires a longer period than the maximum time frame for the selected will be rejected, and projects that fall within the time frame will be accepted.
One of the problems with the payback method is that it ignores cash flows beyond the payback period.
Why it is used?
Very simple to use compared to other methods.
Projects with a faster payback period normally have more favorable short-term effects on earnings.
If a firm is short on cash, it may prefer to use the payback method because it provides a faster return of funds.
© 2007 Thomson/South-Western. All rights reserved.

29. Capital Budgeting (cont’d)
Net Present Value (NPV) Method
The premise that a dollar today is worth more than a dollar in the future.
The cost of capital is the rate used to adjust future cash flows to determine their value in present period terms.
This procedure is referred to as discounting the future cash flows—cash value is determined by the present value of the cash flow.
Internal Rate of Return (IRR method)
Similar to the net present value method, but future cash flows are discounted a rate that makes the net present value of the project equal to zero.
© 2007 Thomson/South-Western. All rights reserved.

30. Break-Even Analysis Contribution Margin Approach
The difference between the selling price and the variable cost per unit.
It is the amount per unit that is contributed to covering all other costs.
0 = (SP –VC)S – FC or FC = (SP – VC)S
where:
SP = Unit selling price
VC = Variable cost per unit
S = Sales in units
FC = Total fixed costs
© 2007 Thomson/South-Western. All rights reserved.

31. Break-Even Analysis (cont’d)
Graphic Approach
Graphing total revenue and total costs.
The intersection of these two lines (that is, where total revenues are equal to the total costs) is the firm’s break-even point.
Two additional costs—variable costs and fixed costs—also may be plotted.
Handling Questionable Costs
Certain costs can behave as either fixed or variable costs at different levels of output: 0=(SP-VC)S-FC-QC or 0=[SP-VC-(QC/U)]S-FC
© 2007 Thomson/South-Western. All rights reserved.

32. Figure 10.2 General Manufacturing: Fixed-Cost Assumption
© 2007 Thomson/South-Western. All rights reserved.

33. Figure 10.3 General Manufacturing: Variable-Cost Assumption
© 2007 Thomson/South-Western. All rights reserved.

34. Ratio Analysis Ratios are useful for: Vertical Analysis
Anticipating conditions and as a starting point for planning actions.
Showing relationships among financial statement accounts.
Vertical Analysis
The application of ratio analysis to identify financial strengths and weaknesses.
Horizontal Analysis
Looks at financial statements and ratios over time for positive and negative trends.
© 2007 Thomson/South-Western. All rights reserved.

35. Financial Statement Ratios
Balance Sheet
Current Assets
Current Ratio =
Current Liabilities
Cash + Accounts Receivable
Quick Ratio =
Current Liabilities
Income Statement
Gross Margin
Gross Margin =
Sales
Net Profit before Tax
Net Margin =
Sales
© 2007 Thomson/South-Western. All rights reserved.

36. Overall Efficiency Ratios
Sales
Sales-to-Assets=
Total Assets
Net Profit before Tax
Return on Assets= (ROA)
Total Assets
Net Profit before Tax
Return on Investment= (ROI)
Net Worth
© 2007 Thomson/South-Western. All rights reserved.

37. Specific Efficiency Ratios
Inventory Turnover
Average Collection Period
Cost of Goods Sold
360
Inventory
Accounts Receivable Turnover
Inventory Turn-days
Accounts Payable Turnover
360
Cost of Goods Sold
Inventory Turnover
Accounts Payable
Accounts Receivable Turnover
Accounts Receivable Turnover
Sales
360
Accounts Receivable
Accounts Receivable Turnover
© 2007 Thomson/South-Western. All rights reserved.

38. Key Terms and Concepts break-even analysis budget capital budgeting
cash-flow budget
contribution margin approach
expenses
fixed cost
horizontal analysis
internal rate of return (IRR) method
mixed cost
net present value (NPV) method
operating budget
payback method
pro forma statement
ratios
sales forecast
simple linear regression
variable cost
vertical analysis
© 2007 Thomson/South-Western. All rights reserved.